Where We’ve Been On Brazil
Obviously the title of this note is a bit harsh. Brazil is a $2.4T economy with a population of over 200 million individuals; our harsh criticism of the country’s disastrous Growth/Inflation/Policy dynamics is in no way aimed at them – with the noteworthy exception of a few government officials.
Brazil is an economy that we’ve been generally negative on over the years due to perpetual fiscal and monetary policy mismanagement. In fact, we were bearish on Brazilian equities and the BRL for over a year leading up to our bullish February 27th presentation titled, “Time To Buy Brazil?”. Concurrent with that research recommendation, the iShares MSCI Brazil Capped ETF (EWZ) declined -25.8% (vs. a +12.8% gain for the MSCI All-Country World Index), while the WisdomTree Brazilian Real Strategy Fund (BZF) declined -8.4%.
Fast forward to today, we were fortunate to have booked gains on June 3rd in the EWZ ETF (+11.2% vs. a +4.3% advance for the MSCI All-Country World Index), Petrobras-PBR (+21.4%) and the BZF ETF (+3.9%). Moreover, since our bearish July 14th note titled, “SELL BRAZIL?”, the EWZ ETF has plummeted -15.8% – including a -9.6% plunge in the week-to-date alone – and is underperforming the MSCI All-Country World Index’s -3.6% decline (since 7/14) by a whopping 1219bps!
It’s worth noting that our call then wasn’t to short Brazil, but rather to just completely divest your exposure. At the time there remained enough open-the-envelope risk to perpetuate a squeeze higher in Brazilian financial assets – most notably the entrance of Marina Silva into the presidential race.
Rousseff’s Policies To Stagflate Look Set To Continue
Unfortunately for what had been crowded Brazil longs, Silva’s presidential hopes now appear rather bleak.
According to a Datafolha poll released yesterday on Folha de S.Paulo’s website, Rousseff would garner 40% of votes in the first round, while Silva would get 25%. The survey of 7,520 interviewees conducted September 29-30th with a margin of error +/- 2ppts. also showed that Rousseff would win 49% of votes in a potential head-to-head runoff on October 26th compared to Silva’s projected 41%. An August 28-29th poll showed that Silva actually had a lead of 10ppts. in the same runoff scenario versus Rousseff’s then-projected 40%.
In line with our July concerns, Rousseff used the bully pulpit afforded to her by her incumbency and her lion’s share of TV and radio ad time (which is based on congressional representation) to attack Silva’s campaign promises to cut inflation in half, promote central bank autonomy and establish an independent fiscal oversight committee, labeling them as “recessionary” and “inconsistent” with her promises to continue supporting the same lower-class she herself emerged from.
Furthermore, Rousseff was able to aggressively tout the benefits of the welfare programs championed by her Worker’s Party (PT) – which have helped to lift many millions of Brazilians out of poverty since former Brazilian president Lula da Silva introduced them during his tenure. Her promises to expand Bolsa Familia (cash transfer program) and Minha Casa Minha Vida (affordable housing) in conjunction with President Lula campaigning on her behalf appears to have been too much for Silva to overcome.
Ironically, it is because of the expansionary nature of such programs, other fiscal tomfoolery (e.g. “loans” to BNDES) and interference with the setting of interest rates, that inflation has exceeded the midpoint of the central bank’s target range for 48 consecutive months. Now the country is mired in recession with ZERO scope to ease either monetary or fiscal policy.
Moreover, we expect the stagflation to continue through at least year-end amid an exodus of foreign capital that is weighing on the exchange rate (down -9.5% MoM). It’s worth reiterating that Brazil is a current account deficit nation that requires foreign capital to plug the hole between gross domestic investment – which, at 18%, actually remains far too low on a comparative basis versus its peers – and gross national savings. All things being equal, slower net capital inflows directly translate to a slower pace of economic activity in Brazil.
Even If Silva Surprises, It’s Unlikely To Matter
Again, a Rousseff victory and four more years of fiscal and monetary policy mismanagement is likely in the cards for Brazil. Investors who are still holding out hope for a come-from-behind victory out of the Silva camp will be sorely disappointed when they consider the following arguments:
- Aecio Neves is currently being endorsed by nearly one-fifth of the Brazilian electorate, which means harnessing the support of his base could potentially decide the election in the 2nd round runoff. While that appears positive for Silva’s chances given his anti-incumbency stance and the adversarial nature of his Social Democratic Party’s (PSDB) relationship with Rousseff’s Worker’s Party (PT), he and Silva have been aggressively attacking each other for weeks on the campaign trail. Getting behind Silva and her left-leaning Brazilian Socialist Party (PSB) would be a tough sell to his supporters.
- Moreover, a recent Datafolha poll showed that of those casting their vote for Neves in the first round, 58% would switch to Silva in the runoff versus 24% to Rousseff, effectively confirming what’s already being priced into the markets – i.e. a Rousseff victory.
- Even if Silva were to somehow pull off the now-presumed impossible and deliver an upset on Sunday, her ability to govern and enact the structural reforms Brazil so desperately needs is VERY limited. Currently, her coalition only has 36 members of Congress; this compares to 391 in Rousseff’s alliance and 142 in Neves’ camp. Aside from a common disdain for the Rousseff administration, the ideological divide between the PSB and PSDB is likely too great for Silva to overcome in terms of forming a large-enough coalition to govern effectively.
All told, the outlook for Brazilian politics is looking increasingly like a lose-lose situation for investors. While arresting the rate of fiscal deterioration and monetary policy mismanagement is positive on the margin, we don’t think that’ll be supportive enough to perpetuate either sustainable economic growth, rising structural growth expectations or the steady stream of capital inflows that would come with it.
Be it another four years of Rousseff or four years of a likely ineffective Marina Silva administration, we think investors should prepare for another four years of Brazil failing to live up to its growth potential.
Budgetary Shenanigans Continue as Brazil Trudges Towards Junk Status
One key issue we continue to highlight is the fact that Brazilian policymakers failed to failed to respond to 12-18M of consensus expectations for [and actual] US monetary and fiscal policy tightening with credible tightening of their own. Both the current account deficit and sovereign budget deficit are actually wider now as a percentage of GDP than they were when last year’s “taper tantrum” began: -3.4% in 2Q14 versus -2.9% in 2Q13 and -3.8% in 2Q14 versus -3.2% in 2Q13, respectively.
Be it “over-promising and under-delivering” or “creative accounting”, not much has changed with respect to Brazilian monetary policy. For example, outgoing Finance Minister Guido Mantega just authorized a withdrawal of 3.5B reais ($1.4B) from Brazil’s sovereign wealth fund to help meet fiscal targets. In defending the move, he remarked, “Nothing is more legitimate than using that fund to cover part of expenses.” Well, maybe except tax revenues…
In addition, Brazil’s primary budget deficit “unexpectedly” widened in AUG to 10.4B reais from 2.2B prior after the government cut taxes and boosted spending ahead of the election. The total primary surplus accumulated over the TTM fell to 0.9% of GDP from a revised 1.2% in JUL and is well shy of the Finance Ministry’s 1.9% target for the current fiscal year.
With trends like these, it’s no surprise to see that Moody’s just recently cut its ratings outlook for Brazil to “negative”. It is likely that they join Standard & Poor’s in rating the country just one level above junk status at some point over the intermediate term.
Investment Conclusion: Remain Uninvested/Underweight Brazil
Our Tactical Asset Class Rotation Model (TACRM) is currently generating “SELL” signals for the iShares MSCI Brazil Capped ETF (EWZ), the iShares MSCI Brazil Small-Cap ETF (EWZS) and the WisdomTree Brazilian Real Strategy Fund (BZF):
Moreover, TACRM is also generating “high-conviction SELL” signals for both EM Equities and Commodities, as well as a “low-conviction SELL” signal for Foreign Exchange. All three of these primary asset class signals corroborate the aforementioned “SELL” signals being generated for Brazilian equity and currency exposure:
In addition to those quantitative signals, we remain negative on the Chinese economy – i.e. Brazil’s largest export market – as well as emerging market asset prices broadly. If you’re looking to get up to speed on our latest thoughts on these fundamental research views, we encourage you to review the following notes:
- DEFCON 2.5: THE “CHINA OVERHANG” IS LIKELY TO CONTINUE (9/30): We believe prospects are rising for another leg down in consensus expectations for Chinese growth.
- EMERGING MARKETS: THE EM RELIEF RALLY IS LIKELY OVER (9/23): Consistent with recent quantitative developments and our fundamental GIP process, we now think the risk is to the downside for EM Equities.
The reason we aren’t recommending that you short Brazil here is two-fold:
- Good luck finding a reasonably-priced borrow or inexpensive put options here!
- The country is currently in recession. It won’t be in recession indefinitely. In fact, base effects would suggest Brazil is likely to be on the road to what may ultimately turn out to be another disappointing recovery by the first quarter of next year. Surely by 2Q15.
Again, Brazil isn’t going to remain in recession permanently so the risk/reward of shorting it down here is not as favorable as we’d like. We are by no means arguing that Brazil has turned the corner from an economic growth perspective, but there’s a lot more green on this table than one might expect given the recessionary nature of the Brazilian economy:
All told, we think Brazil’s economic and political malaise appears set to continue. As such, we think investors should remain uninvested/underweight Brazil.
Poor Brazil; the country just can't seem to get out of its own way...
Associate: Macro Team